ExpertInsights@IBV

Programmable money
Will central banks take the lead? IBM Institute for Business Value
2 Programmable money

Blockchain comes alive

The financial services industry is exploring the
promise of blockchain technology. A variety of
consortia, including the business-focused
Digital Trade Chain Consortium and the
technology-focused Hyperledger, have been
having thoughtful discussions. These discussions
and experimentation have given rise to
collaborative pilots and private implementations.
Some of these pilots have now matured into
production systems. Many high-impact projects
are likely to be implemented within the next
12 months.
Programmable money
A spectrum of commercial potential
Blockchain networks hold tremendous power
in their ability to boost security, which can help
ensure data integrity, promote transaction and
settlement efficiency, and verify identity.
However, many current business applications
of blockchain are still in experimental stages.
Use cases range from academic research
experiments to the eventual issuance of central
bank digital currency. Although mainstream
adoption of blockchain applications is nascent,
it’s advancing swiftly.
Bankers, in particular, seem cautiously opti-
mistic about blockchain. In a 2016 survey of 200
banks across 16 countries by the IBM Institute of
Business Value, 91 percent of the surveyed
banks said they are investing in blockchain
solutions for deposit taking by 2018. As technol-
1
ogies mature, commercial initiatives often
become more imaginative and bold, so as
blockchain adoption moves out of the sandbox,
the drivers will become more ambitious. Goals
may include new revenue generation, enhanced
client experience, improved competitive
advantage and increased social impact.
The future of money
Blockchain came to prominence as the digital
ledger technology for the crypto-currency
known as Bitcoin. This programmable money
has been a double-edged sword to the world.
On one hand, it proved the feasibility of a
self-regulating, global, digital, peer-to-peer
payment network, operating without a trusted
third-party intermediary (such as a bank, credit
card company or payment company). On the
other hand, Bitcoin has tended to promote
the perception among an increasingly digital
populace that banks are no longer necessary.
Many consumers believe that money should
move as easily as email. A growing number of
articles debate whether the current banking
system or even banks themselves are becoming
obsolete. Many people believe that if banks
were cut out as an intermediary, payments
could be simpler, autonomous and instanta-
neous. A number of these articles describe the
3
following principles for ideal digital money.
The first is that money should be intrinsically
connected to the internet, unconstrained by
geography or institutions. Second is that foreign
exchange should be immediate. Third is that all
transactions should be free. The thinking goes
that if sending messages using email is free,
why shouldn’t sending money also be free?
Although the principles of digital money are
valuable and achievable, banks will continue to
play a key role in the global financial system and
economy established by central authorities.
These authorities direct banks to allocate funds
from savers to borrowers in an efficient, fair and
equitable manner. Banks also will continue to
perform critical everyday operational tasks such
as verifying identities, monitoring transactions
for fraud, preventing money laundering and filing
suspicious activity reports to government and
law enforcement. These activities are invisible to
most retail consumers of banking services.
4 Programmable money
91 percent of the surveyed
banks said they are investing
in blockchain solutions for
deposit taking by 2018
Blockchain payment networks: near and clear
Blockchain has emerged as an ideal technology
for payments because of its exemplary
transaction and settlement security, data integrity,
record-keeping and efficiency features.
The payments industry offers promising
opportunities. Cross-border e-commerce is now
growing at more than 20 percent annually, which
is more than double the growth rate for domestic
e-commerce.2 On aggregate, cross-border
payments account for about 40 percent of global
banking revenues with payment flows of more
than $135 trillion during 2016.3
Even though there is no practical reason in the
digital era why a global payment transaction
should cost any more than a domestic
transaction, global payments have higher
complexity and currency exchange costs than
their domestic counterparts. . In fact, the friction
plus fee reconciliation is what makes cross-border
payments expensive.
It’s expensive to be poor!
Setting aside the risk and regulatory concerns
for programmable money, few technical barriers
prevent the creation of a real-time, cost-effective
global payment network capable of supporting
most transaction types with straight-through
processing.
Within the more complex wholesale banking
space, international settlement volume is
measured in trillions of dollars (USD) each day.4
The opportunities to increase operational
efficiency alone are enormous. But the
institutional structures and relationships
supporting this volume are resistant to change.
Blockchain will be an important catalyst and
enabler for an impending major paradigm shift in
payments. But in the meantime, early adopters
want to see stable, scalable and cost-effective
solutions that can be deployed in parallel to
existing financial rails, so migration can be gradual,
rather than a risky all-or-nothing proposition.
Programmable money
Three design patterns for international payments
Numerous blockchain experiments for
international payments have been conducted in
recent years. Virtually all of them fall into three
design patterns: the custodian model, the
correspondent model, and the digital asset
model (see Figure 1). The custodian and
correspondent models are well represented
within today’s existing payments networks.
These models are used by large foreign-
exchange settlement firms that support daily
net settlement of major banks around the world.
They also are used for vast correspondent
messaging networks that support payment
instruction routing and clearing. Applying
blockchain technology to either of these
models can offer incremental innovation to
existing functionality. However, blockchain
doesn’t offer the transformational change that
Bitcoin has inspired.
5
Unlike the custodian and correspondent initiating transfer instructions and a native asset
models, the digital asset model addresses to settle those transactions near real-time.
clearing and settlement on a single network. It Because the settlement asset or digital currency
has been popularized by the design principles of is a purely digital instrument, near real-time
Bitcoin and appears to offer the most disruptive foreign exchange becomes just another step
potential. Under this model, payment instruction within a composite transaction. All of the steps,
history, along with an immutable transaction from payment instruction to clearing, to
ledger, and the means for settlement, are settlement and foreign exchange, can be
combined onto a single network. The digital encapsulated into a single atomic transaction
asset model provides an integrated network for that executes in near real-time.
Figure 1
Blockchain design approaches
Custodial Correspondent Digital asset
• Transfers must be • Funds are made immediately • Clearing and settlement are
pre-funded to support available via instant credit transfers performed on the same
settlement • Instant credit transfers are network in near real time
• Reserves are deposited into decoupled from fund movement • There is no pre-funding
a multi-currency custodian (settlement) requirement
account • Payment is assured via legal • Transactions are atomic and
• Payment is the recorded constructs between counterparties’ settled instantly by exchange
movement of balances jurisdictions and bi-lateral netting of a digital monetary asset
between counterparties agreements between participants • Digital assets are also used as
• Transactions are atomic and • Settlement is deferred and an intermediary bridge for FX
settlement is instant asynchronously performed on
a different network
Settlement focus Clearing focus Clearing and settlement focus
Source: IBM analysis
6 Programmable money
It’s time for a close-up
Even at a price of USD The problem with the digital asset model is the
lack of confidence in the underlying digital asset.
10,000, Bitcoin only has a Legitimate questions arise about who controls the
market capitalization of exchange rates for digital currencies, resurfacing
about USD 170 billion fears of foreign exchange market manipulation
and concerns for liquidity provision. Although
some “altcoin” alternatives might satisfy the digital
asset requirements for this design pattern, only a
few are actually viable.
One of the alternatives is Bitcoin, but concerns
about transaction costs, transaction speed,
contentious forking, scalability and especially a
limited money supply have hindered Bitcoin’s
widespread adoption as a commercial payment
solution. For example, even at a price of USD
10,000, Bitcoin only has a market capitalization of
about USD 170 billion.5 In contrast, almost five
years ago, JP Morgan alone was moving USD 2-5
trillion daily.6 Alternatives to Bitcoin have been built
specifically for payment applications and feature
scalable, secure technology.

Central bank obsolescence? Not likely
None of this discussion is lost on central bankers.
Around the world, central bankers are actively
involved in understanding and even experimenting
with digital currencies. In fact, nothing is stopping
a central bank from issuing a digital version of its
fiat currency today.7
Currently, in Sweden, Riksbank is experimenting
with eKrona, and the Bank of Canada is working
on a proof-of-concept with CADcoin.8 Issuing fiat
on a blockchain has numerous benefits. The
traceability of blockchain would help prevent
financial crimes such as money laundering and
corruption, and the efficiency of blockchain will
reduce transaction and settlement frictions.
The bottom line
The mass adoption of Bitcoin shows that the
world has an appetite for blockchain-based digital
currencies and payment. Whether it’s Bitcoin or a
central bank issuance, digital currencies can offer
tangible improvements to financial services by
increasing security and reducing friction,
particularly in international payments. Generally,
more transparency, traceability and security can
promote trust between counterparties and help
accelerate financial inclusion. Anyone with a
mobile device could access a digital money wallet
to serve as a bank account, essentially “banking”
a large percentage of the approximately two billion
unbanked adults.9 Programmable money can
be designed to flow as easily as email without
sacrificing regulatory controls, monetary policy
or personal privacy.
The future of programmable money is dawning.
While blockchain adoption is still in a formative
stage, it offers tremendous potential to revolu-
tionize the global financial system. No place on
earth will be out of reach.
7
Experts on this topic
Jed McCaleb
Stellar Cofounder and Chief Technical Officer
linkedin.com/in/jed-mccaleb-4052a4/
jed@stellar.org
Lindsay Lin
Counsel and Program Manager, Lightyear.io
linkedin.com/in/lindsayxlin/
Lindsay.lin@lightyear.io
Jesse Lund
Vice President, Global Blockchain
Market Development
IBM Financial Services Sector
linkedin.com/in/jesselund/
Jesse.Lund@ibm.com
About ExpertInsights@IBV reports
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Notes and sources
1 “Leading the pack in blockchain banking: Trailblazers set
the pace” IBM Institute for Business Value. 2016. https://
www-01.ibm.com/common/ssi/cgi-bin/
ssialias?htmlfid=GBP03467USEN
2 The Global E-Commerce Payments Guide” Adyen.
https://www.adyen.com/blog/
the-global-e-commerce-payments-guide
3 Bajpai, Prableen. “How Blockchain Is Being Used To
Solve Cross-Border Payments Problems.” NASDAQ.
October 24, 2017. http://www.nasdaq.com/article/
how-blockchain-is-being-used-to-solve-crossborder-
payments-problems-cm864095
4 Young, Michael, S. “All Trading Systems Are Not Created
Equal.” Equities.com. October 13, 2017. https://www.
equities.com/news/all-trading-systems-are-
not-created-equal
5 Godbole, Omkar. “It’s Official: Bitcoin’s Price Makes
History Passing $10k” Coindesk. November 29, 2017.
https://www.coindesk.com/10000-bitcoins-price-
makes-history/
6 Lopez, Linette. “Jamie Dimon: We Have A Secret
Money Room Somewhere In Florida That Moves
$2-$5 Trillion Every Day” Business Insider. February
4, 2013. http://www.businessinsider.com/
jp-morgan-has-a-secret-money-room-2013-2
7 “Fiat currency is legal tender whose value is backed
by the government that issued it. The U.S. dollar is fiat
money, as are the euro and many other major world
currencies.” Hall, Jason. “Fiat Currency: What It Is and
Why It’s Better Than a Gold Standard” The Motley
Fool. January 4, 2017. https://www.fool.com/
investing/general/2015/12/06/fiat-currency-what-it-
is-and-why-its-better-than-a.aspx
8 Bech, Morten Linnemann and Rodney Garratt.
“Central bank cryptocurrencies” Bank for
International Settlements. September 17, 2017. https://
www.bis.org/publ/qtrpdf/r_qt1709f.htm
9 Financial Inclusion. The World Bank. April 5, 2017.
http://www.worldbank.org/en/topic/
financialinclusion/overview#1